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Text of Severed Letter

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Following the decision in Transalta Corp. v. the Queen (2012 DTC 1106), we have received several enquiries from auditors on the meaning of the word “agreement” for the purposes of the employee stock option rules in section 7 and paragraph 110(1)(d) (footnote 1). We are writing to provide you with our views on the matter.

Our comments

Section 7 applies where a corporation has agreed to sell or issue its shares (or shares of a non-arm’s length corporation) to an employee of the corporation (or a non-arm’s length corporation). (footnote 2) If there is no agreement, section 7 cannot be applied. The meaning of agreement is also relevant for the one-half deduction for employee stock option benefits in paragraph 110(1)(d) as several of the eligibility conditions depend on the timing of when the option agreement is considered to have been made. Most notably, the exercise price under the option must be at least equal to the fair market value of the shares at the time the corporation grants the option to the employee (less any amount paid by the employee to acquire the option if applicable).

Case law

Over the years, the Courts have given broad meaning to the words “agreed” and “agreement” for the purposes of section 7 and paragraph 110(1)(d). The Federal Court of Appeal held in Placer Dome v. Canada (92 DTC 6402) that a program which was not a traditional stock option or share purchase plan was still an agreement for the purpose of section 7 because it had the effect of granting to employees a right to purchase shares at a discount. In MNR v Chrysler Canada Ltd (92 DTC 6346), it was found that an agreement for the purposes of section 7 can include an oral or implied agreement. In McAnulty v. R. (2001 DTC 942), the Tax Court held that an oral commitment to give an employee the right to purchase shares constituted an agreement for the purposes of the stock option deduction in paragraph 110(1)(d), even though there was no consideration given by the employee for the right.

Although obiter comments in McAnulty contemplated that an agreement might include a non-binding commitment, these cases (including McAnulty) all dealt with situations where the employees had a right to purchase or acquire shares and thus involved something more than a mere undertaking. These cases stand for the proposition that an arrangement to issue or sell shares need not be a detailed written contract to fall within the scope of section 7 or paragraph 110(1)(d), but nonetheless must create legally binding rights and enforceable obligations.

This principle was confirmed in Transalta where the Tax Court concluded that arrangements that involve a non-contractual commitment or undertaking by a corporation to issue its shares to employees fall outside the scope of section 7. The Court found that section 7 applies only to legally binding agreements.

Although Transalta involved only one type of share-based compensation plan, we consider that the principle applies broadly. It is our position that the application of section 7 and paragraph 110(1)(d) requires in all situations the existence of a legally binding agreement.

Comments on various share-based compensation plans

The following are general comments on various share-based compensation plans. It should be noted that the determination of whether a particular arrangement constitutes a legally binding agreement to issue or sell shares and at what point in time such an agreement comes into existence will depend on the principles of contract law and a review of all of the facts.

1. Discretionary share bonus plan

This is essentially the same fact pattern considered in Transalta. A corporation offers a share bonus plan to its employees. At the beginning of each three-year period, the corporation advises each participating employee of the maximum number of shares that could be earned as a bonus for the period. The corporation determines at the end of the period the number of shares earned and whether the bonus would be paid in the form of shares issued from treasury or cash equivalent. Payment of the bonus and the form of payment is entirely at the discretion of the corporation. None of the employees are granted any right to participate in the share bonus plan by their employment contract. Nor are there any performance conditions set out in the plan which, if met, would entitle the employees to receive any bonus. Once the corporation decides that an employee was entitled to a bonus, the corporation was free to choose how to satisfy the bonus either by issuing shares from treasury or by paying the equivalent in cash. The employee has no right to require payment be made in shares.

Because the corporation’s commitment remains fully discretionary at all times, the arrangement does not give rise to a legally binding agreement for the purposes of section 7. Therefore, where the corporation opts to settle the bonus by issuing shares, paragraph 7(3)(b) does not apply to prohibit the corporation from deducting the bonus expense.

Similarly, a fully discretionary stock bonus plan without a cash option will also fall outside section 7 where the granting of the awards and the issuance of the shares is made concurrently. However, if the eventual issuance of the shares is subject to time or other objective vesting conditions, it is our view that section 7 would apply. Despite the fact that the initial decision of the corporation to grant the share awards was fully discretionary, once granted the employee would have a legally enforceable right to acquire the shares at a future date conditional on satisfying the vesting conditions.

In this regard, a key consideration for auditors is the salary deferral arrangement (SDA) rules of the Income Tax Act. Currently, most tax advisors take the position that a share bonus plan that falls within section 7 is exempted from the application of the SDA rules. A share bonus plan that has been designed to avoid the application of paragraph 7(3)(b) (by the inclusion of a discretionary cash settlement option) will also need to be designed to avoid the application of the SDA rules. Generally speaking, this will require the plan to fit within one of the enumerated exceptions to the SDA rules, notably paragraph (k) of the SDA definition in subsection 248(1) (three-year bonus plans) or paragraph 6801(d) of the Income Tax Regulations (deferred share unit plans). If the SDA rules were found to apply to a share bonus plan, it would result in the share awards being taxed to the employee on a current basis by virtue of subsection 6(11).

It is expected that many corporations that qualify as a Canadian-controlled private corporation (CCPC) will wish to continue to structure share bonus plans to fit within section 7 because of the preferential tax treatment afforded to employees by virtue of subsection 7(1.1) (taxation of stock option benefit deferred until disposition of shares) and paragraph 110(1)(d.1) (one-half deduction). This treatment is often viewed as outweighing the lack of deduction for the corporation. Relying on the obiter comments in McAnulty referred to above, it is understood that certain CCPCs took the position that vesting conditions and other features of share awards could be highly discretionary or subjective (e.g., an informal undertaking to issue shares that was only ratified at a later date) and still fall within the ambit of section 7 and paragraph 110(1)(d.1). The terms of arrangements that purport to benefit from these provisions should be carefully reviewed by auditors to confirm that the arrangement does constitute a legally binding agreement and with such effect from a time sufficient to satisfy the minimum two-year hold requirement in subparagraph 110(1)(d.1)(ii). See 5 below for comments on a discretionary employee stock trust.

2. Employee share purchase plan

A public corporation offers its employees the right to purchase common shares of the corporation at a 10% discount, up to a specified number of shares. At the beginning of the year, each employee notifies the corporation of the number of shares they wish to purchase and how they wish to pay for the shares (either by direct payment or payroll deduction). The corporation then sends a notice to the employee confirming the purchase. Once the employee fully pays for the share purchase, the corporation issues the shares from treasury to the employee’s brokerage account.

As this arrangement constitutes a legally binding agreement to issue shares, paragraph 7(3)(b) will apply to prohibit the corporation from deducting the employee compensation expense relating to the share discount.

A public corporation offers both a SAR plan and a DSU plan to its senior employees. The number of units issued under each plan to participants is individually negotiated each year as part of the participant’s employment contract.

A SAR unit entitles the participant to a payment at the end of the vesting period equal to the increase in value of one common share of the corporation from the date of issuance of the SAR to the vesting date. A DSU entitles the participant to a payment equal to the value of one common share of the corporation determined as at the earliest date on which the participant retires, terminates employment or dies. As the DSU plan is designed to fit within the parameters of paragraph 6801(d) of the Regulations, the payment cannot be made any earlier than that date and must be made no later than the end of the following calendar year. The corporation has complete discretion under both plans to make the payment in cash, in shares issued from treasury or in any combination of cash and shares.

Although both of these arrangements give rise to a legally binding agreement with respect to the making of the payment, there is no agreement to issue shares as contemplated by section 7. This is because the corporation is free to choose the form in which the payment will be made (which includes cash). Accordingly, paragraph 7(3)(b) will not apply to prohibit the corporation from deducting the employee compensation expense.

4. Employee stock options with discretionary vesting condition

A corporation grants options to acquire shares to its employees. The options expire on a pro-rata basis over a five-year period. The exercise price is the price of the shares at the date of grant. The options are exercisable only upon receipt of a notice from the corporation. Each year, the corporation decides on the number of options that each employee may exercise and immediately sends a notice to the employee confirming the decision. Upon receipt of the notice, the employee can then exercise the options.

We would not consider there to be an agreement to issue shares at the time of the initial grant for the purposes of section 7 and paragraph 110(1)(d). Such an agreement would be considered to arise only at the time the notice is sent by the corporation to the employee and only in respect of the number of shares set out in the notice. Before that time, the employee had no enforceable right to acquire the shares and the corporation had no binding obligation to issue the shares. Consequently, the employee would not qualify for the paragraph 110(1)(d) deduction where the share price had increased from the date of the grant to the date of the notice.

5. Discretionary employee stock trust

A CCPC establishes a trust to acquire and hold shares of the corporation for the benefit of its employees. The trustees include the corporation’s controlling shareholder. The beneficiaries of the trust are employees of the corporation listed by name only in a schedule to the trust and such other employees as may be designated by the board of directors from time to time. Allocations and distributions from the trust are entirely at the discretion of the trustees.

The trust subscribes to a specified number of newly-issued common shares of the corporation for nominal consideration shortly after an estate freeze is undertaken. Several years later and after appreciation in the value of the shares, the trustees decide to distribute the shares to certain beneficiaries in accordance with an allocation determined by the trustees at that time. This was the first time the trustees allocated any property to specific beneficiaries. The beneficiaries who participated in the distribution included both individuals who were employed when the trust was established as well as individuals who were hired afterwards. The beneficiaries were required to sign a document acknowledging that the distribution was at the discretion of the trustees and agreeing to sell the shares, at a pre-set price and immediately upon distribution, to a related corporation.

The corporation and employees take the position that the arrangement is governed by section 7 and, in particular, that the employees were deemed by paragraph 7(2)(a) to have acquired the shares when they were first acquired by the trust. As a result, they claim that the full amount of the gain on disposition of the shares is taxable to the employees as a capital gain and eligible for the capital gains deduction in section 110.6.

We do not agree with this position.

In general, where contributions made by a corporation to a trust established for the benefit of its employees are used to acquire shares of the corporation, the arrangement will either be subject to section 7 or the employee benefit plan (EBP) rules of the Act depending on the facts. If both section 7 and the EBP rules apply to the same arrangement, the courts have held that section 7 has priority being the more specific of the two provisions (see Chrysler above).

A trust arrangement that provides for allocations and distributions of employer shares on a fully discretionary basis would not be governed by section 7. Such a discretionary arrangement lacks the requisite legally binding agreement as neither the corporation nor the trustees have any obligation to transfer shares to any specific beneficiary and no particular beneficiary has any enforceable right to shares until the discretion is exercised. In this case, the trustees maintained full discretion as to whether, and the extent to which, any particular beneficiary would be entitled to a distribution from the trust. The trustees first allocated shares to specific beneficiaries only just before the distributions, many years after the trust acquired the shares.

On this point, it is worth noting that subsection 7(2) does not serve to deem there to be a legally binding agreement to issue or sell shares where such an agreement does not in fact exist. The provision has no relevance, and therefore no application, in the absence of a legally binding agreement. Also, subsection 7(2) cannot apply any earlier than when a specific number of shares have been allocated to an identifiable employee pursuant to a legally binding agreement to issue or sell shares.

Since section 7 would not be applicable, the income tax treatment would be determined under the EBP rules. In particular, the fair market value of the shares distributed from the trust to each beneficiary (determined at the time of the distribution) would be required to be included in the beneficiary’s income pursuant to paragraph 6(1)(g). In other words, the full value of the shares would be taxable to the employees as employment income and the capital gains deduction would not be available.

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 All statutory references are to the Income Tax Act.
2 Section 7 and paragraph 110(1)(d) also apply to the sale or issuance of units of a mutual fund trust to an employee. For ease of readability, this memo refers only to shares of a corporation, but the comments apply equally to units of a mutual fund trust.

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In response to several enquiries from auditors on the meaning of “agreement” for the purposes of ss. 7 and 110(1)(d), the Directorate first referenced the Placer Dome, Chrysler and McAnulty decisions, and stated:

These cases stand for the proposition that an arrangement to issue or sell shares need not be a detailed written contract to fall within the scope of section 7 or paragraph 110(1)(d), but nonetheless must create legally binding rights and enforceable obligations.

The Directorate then discussed this issue in the context of various types of plans.

Respecting a discretionary share bonus plan (where “the corporation determines at the end of the [3-year] period the number of shares earned and whether the bonus would be paid in the form of shares issued from treasury or cash equivalent.,” it stated:

Because the corporation’s commitment remains fully discretionary at all times, the arrangement does not give rise to a legally binding agreement for the purposes of section 7. Therefore, where the corporation opts to settle the bonus by issuing shares, paragraph 7(3)(b) does not apply to prohibit the corporation from deducting the bonus expense.

Similarly, a fully discretionary stock bonus plan without a cash option will also fall outside section 7 where the granting of the awards and the issuance of the shares is made concurrently. However, if the eventual issuance of the shares is subject to time or other objective vesting conditions, it is our view that section 7 would apply. …

A share bonus plan that has been designed to avoid the application of paragraph 7(3)(b) (by the inclusion of a discretionary cash settlement option) will also need to… [qualify as a] three-year bonus plans… deferred share unit plan… .

Respecting a SAR or DSU plan, because “there is no agreement to issue shares…[i.e.,] the corporation is free to choose the form in which the payment will be made (which includes cash) [a]ccordingly, paragraph 7(3)(b) will not apply… .

CRA first stated that Placer Dome, Chrysler and McAnulty “stand for the proposition that an arrangement to issue or sell shares need not be a detailed written contract to fall within the scope of section 7 or paragraph 110(1)(d), but nonetheless must create legally binding rights and enforceable obligations.”

Respecting options with FMV exercise prices granted by the corporate employer which expire on a pro-rata basis over a five-year period, and which are exercisable upon the corporation subsequently notifying of its decision on the number of options that each employee may exercise, the Directorate stated:

[A]n agreement to issue shares… would be considered to arise only at the time the notice is sent by the corporation to the employee and only in respect of the number of shares set out in the notice. Before that time, the employee had no enforceable right to acquire the shares and the corporation had no binding obligation to issue the shares. Consequently, the employee would not qualify for the paragraph 110(1)(d) deduction where the share price had increased from the date of the grant to the date of the notice.

A further situation discussed was where a trust is established by the employer to acquire and hold shares of the corporation for employees, but allocations among the employees are entirely at the discretion of the trustees – so that CRA would consider that there is no agreement to acquire the shares until such discretion is exercised.

CRA first stated that Placer Dome, Chrysler and McAnulty “stand for the proposition that an arrangement to issue or sell shares need not be a detailed written contract to fall within the scope of section 7 or paragraph 110(1)(d), but nonetheless must create legally binding rights and enforceable obligations.”

CRA considered a trust established by a CCPC to acquire and hold shares of the corporation for employees, with allocations among the employees and distributions entirely at the discretion of the trustees. Several years later and after appreciation in the value of the shares, the trustees decide to distribute the shares to employee beneficiaries (including subsequent hires) in accordance with an allocation determined by the trustees at that time. In finding that the s. 110(1)(d) deduction was not available, CRA stated:

A trust arrangement that provides for allocations and distributions of employer shares on a fully discretionary basis would not be governed by section 7. Such a discretionary arrangement lacks the requisite legally binding agreement as neither the corporation nor the trustees have any obligation to transfer shares to any specific beneficiary and no particular beneficiary has any enforceable right to shares until the discretion is exercised. …

[S]ubsection 7(2) cannot apply any earlier than when a specific number of shares have been allocated to an identifiable employee pursuant to a legally binding agreement to issue or sell shares.

Since section 7 would not be applicable, the income tax treatment would be determined under the EBP rules.

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